Question

"The Balance Sheet, Ratio Analysis and the Financial Analyst"

Many financial ratios can be utilized to analyze financial statements. These fall into four (4) primary categories. Many financial analysts tend to utilize one (1) or two (2) of the following ratio categories when evaluating a company: Liquidity Ratios Activity Ratios Profitability Ratios Coverage Ratios Imagine that you are a financial analyst. Discuss the ratios you would most likely focus on when you conduct your analyses. Provide a rationale for your selections.

Answer 1

Definition of Ratio : A ratio is defined as "the indicated quotient of two mathematical expressions and as the relationship between two or more things".

Type of Ratios :

1. Liquidity Ratios

2. Coverage Ratios

3. Activity Ratios

4. Profitability Ratios

As a financial analyst while analyzing the company, we will most likely focus on Liquidity and Profitability Ratios.

Rationale for selection of Liquidity Ratio:

Liquidity or short term solvency means ability of the business to pay its short term liabilities. Inability to pay off short term liabilities affects its credibility as well as the credit rating. Continuous default on the part of the business leads to the commercial bankruptcy. Eventually such commercial bankruptcy may lead to its sickness or dissolution. Short term lenders and creditors of a business are very much interested to know its state of liquidity because of their financial stake. Both lack of sufficient and excess liquidity is bad for the organisation.

Various liquidity ratios are :

a) Current Ratio

b) Quick Ratio

c) Cash Ratio

d) Net working capital Ratio

e) Basic defense Interval or Interval Measure Ratio

Rationale for selection of Profitability Ratio:

The Profitability ratios measure the profitability or the operational efficiency of the firm. These ratios reflects the final results of the business operations. They are some of the most closely watched and widely quoted ratios. Management attempts to maximize these ratios to maximize firm value.

The results of the firm can be evaluated in terms of its earnings with reference to a given level of assets or sales or owner's interest etc. Therefore, the profitability ratios are broadly classified in four categories:

(i) Profitability Ratios related to Sales

(ii) Profitability Ratios related to overall Return on investment

(iii) Profitability Ratios required for Analysis from Owner's Point of View

(iv) Profitability Ratios related to Marked Valuation/ Investors.